Chapter One: Introducing Penny (and the fundamentals of unit economics)
Meet Penny the precocious stick girl.
Penny is only seven years old, but she already knows what she wants to be when she grows up.
She wants to be a successful entrepreneur, because then she’ll be able to afford all of her favorite things: a stick pony, a stick house, a stick convertible (with stick shift—naturally), a stick boat and a stay-at-home stick husband who’s going to raise their children while she’s busy breaking glass ceilings and defying gender stereotypes.
Now, Penny doesn’t like your typical kid activities very much. Instead, she spends her time researching business ideas, and recently she heard about something called “software as a service”—otherwise known as SaaS. While it sounds like a great way to make money, it also seems complicated.
The problem is, Penny is seven years old, and she doesn’t know a damn thing about math. So, much to her mother’s dismay, she asks a lot of questions.
Their conversation about SaaS started like this:
Penny: Mommy, what’s SaaS?
Deborah: Eat your peas, Penny.
Penny: Not until you tell me about SaaS.
Deborah: Fine. Software as a service is when you sell software on an ongoing basis instead of a one-time sale.
Penny: Oh. Why would you want to do that?
Deborah: The same reason your father left, dear. Money.
Penny: I thought he left us for his Puerto Rican barber, José.
Deborah: Penny. Your peas.
Penny: But I still don’t understand SaaS.
Deborah [sighing]: Think about it this way. Back in the nineties, most software used to be sold on CDs or floppy disks, and it was really expensive. The first version of Photoshop was $1,000, and whenever a new version came out, you’d have to pay extra for the upgrade. Now you can get the entire Adobe Creative Suite on a subscription for $50 a month, and it includes the most recent features without having to pay more.
Penny: Wait. Doesn’t Adobe make more when they sell it for $1,000 than $50?
Deborah: You’d think so, but no.
At this point, Deborah reached across the table and used the peas and carrots on Penny’s plate to draw a chart similar to this:
Deborah: The carrot represents how much money it takes to acquire a new customer, including advertising, PR, sales commissions, etc. The peas are how much you make when you license the software on a one-time basis. You’ll earn a lot up front—$1,000 in Adobe’s case—and a year later, you’ll make a little more if the person upgrades to the next version. Say $200.
Penny: Hmm. I bet a lot of people don’t upgrade when they have a choice. Reminds me of this Dilbert cartoon I saw the other day.
[Penny reaches in her pocket and pulls out a comic strip]
Deborah: Ha. That’s exactly it.
Penny: So why are monthly subscriptions better than one-time sales?
Deborah: Because they generate recurring revenue—monthly recurring revenue, also known as MRR. Even if it’s not as much money up front, it ends up being more in the long run. Instead of getting a lot of peas in the first month and none again until the twelfth month, you get consistent peas every month, like this:
Penny: But…but won’t it take longer to get the same amount of peas as the one-time sale? And won’t some customers leave anyway, meaning I get fewer peas every month? I want all the peas to cover my carrot—err, costs—at the start!
Deborah: You sound exactly like your father. When he ran the local newspaper, he never understood the cash impact of a typical SaaS deal either. He preferred to sell print ads. Print ads! He’d make decent money on a one-time sale, and then he’d have to convince the same client to buy the same thing next year. And look where that got him.
Penny: In Puerto Rico with José?
Deborah: Unemployed. I remember him coming home every night, pouring a drink, and muttering to himself, “Ten years from now, will my company still be here?” Maybe he should have switched to selling digital. The recurring revenue wouldn’t have saved our marriage, but it might’ve saved his newspaper.
Penny: Hmmmm. I still don’t understand.
Deborah: Take the Adobe example. In year one, they make $1,000 on every upfront sale versus $600 with monthly recurring revenue. By the end of year two, however, the playing field is even—they’ve made $1,200 in both cases. By year three, the total MRR has surpassed the one-time sale plus its upgrades: $1,800 vs $1,400. See the peas:
Deborah: Now, unlike one-time sales, the issue with SaaS is that the amount of money it takes to acquire a customer isn’t recovered immediately—it’s over time. In other words, it creates negative cash flow.
Penny: What’s negative cash flow?
Deborah: Negative cash flow is when more money is flowing out of a business than flowing in during a specific period. For Adobe, their cost to acquire a customer is $600 and their monthly recurring revenue is $50 per month, meaning they won’t be profitable until month fourteen. After that, however, everything is cash positive.
Penny: So the longer you keep a customer around, the more you make?
Deborah: Exactly. In SaaS, the total amount you earn from a customer is their lifetime value, or LTV. The longer you keep them around, the more they’re worth, and if LTV is greater than the cost to acquire a customer—CAC—you’ve got yourself a good business.
Suddenly, something clicked in Penny’s seven-year-old brain.
Penny: Thanks, Mom!
Deborah: Where do you think you’re going?
Penny: I’ve got a business to build.
Deborah: But you’re not done your…ugh. Children.
Chapter Two: Penny builds an agency
With her newfound knowledge of recurring revenue, Penny sprinted to her room and furiously started brainstorming ideas for startups.
While looking out her window, she had an epiphany.
Across the street, her neighbor Timmy had put up a lemonade stand. Upon seeing it, she remembered that her friends Sheena and Chad were running lemonade stands today, too, and she knew other kids were probably thinking the same thing.
Personally, Penny thought Timmy’s lemonade stand was awful. There were no customers! He had set up shop in the middle of nowhere, and nobody seemed to know about it.
She went to work researching marketing tools, and in less than an hour, she had come up with a list of products that she thought could help Timmy succeed. It was a long list: websites, landing pages, review generation tools, social advertising, AdWords and more. Thankfully, instead of having to code this software herself, she found out she could sell white-label solutions, which allow her to customize existing tools and resell them under her own brand. Genius, she thought.
Armed with a contract, Penny marched across the street to Timmy’s yard.
Timmy wasn’t much of a talker. He merely stared at her and blinked.
Penny: Hello? Did you hear what I said? You need marketing help, Timmy.
Penny: First thing’s first, no one can find you online. You need a website and accurate listings at the very least, and you’re going to need to advertise, too. I suggest $100 on search and social to start. I can bundle that together with reputation management and a website package for $200, but I’ll need you to sign right now and throw in a free glass of lemonade. Any questions?
Penny: Great. Now go get your mom’s credit card.
Penny went around town and repeated the same sales pitch at all of the kids’ lemonade stands. At the end of the day, she had three new clients.
Timmy signed up for $200/month, Sheena signed up for $300/mo, and Chad signed up for $500/month. That was $1,000 monthly recurring revenue in the bag—not bad, she thought. Of course, she had racked up $5,000 on her mom’s credit card to purchase the software that she was selling them, but given everything her mother had told her about negative cash flow, she expected to be breaking even by month five.
What could possibly go wrong?
Chapter Three: Penny gets burned by churn
A month later, Penny was giddy with excitement. It was time to run her clients’ credit cards and collect that sweet, sweet recurring revenue.
Only something didn’t go according to plan.
Chad’s credit card didn’t work. She tried once, twice, three times. Declined. Declined. Declined.
Furious, Penny got on the phone and called Chad’s house. Chad’s mother replied and said that Chad couldn’t come to the phone because he was grounded for stealing her Visa the previous month. Apparently the $500 hadn’t gone unnoticed.
Penny panicked. Afraid of how this would affect the value of her company—and, consequently, her ability to retire by the age of ten—she ran to her mother.
Deborah: Penny? What is it?
Penny: Well…uh…remember when we were talking about recurring revenue a few weeks ago? You said the longer you keep customers around, the better, right?
Deborah: That’s right.
Penny: What happens when you lose a customer?
Deborah: That’s called churn. It can strike a devastating blow to the lifetime value of your clients and, subsequently, your company.
Penny: [Gulp] So, umm, say you lose one of your three customers. How bad is that?
Deborah: Depends. Are you looking at customer churn or dollar churn?
Penny: What’s the difference?
Deborah: Customer churn is the number of customers you lose over a period of time. Dollar churn is the lost revenue from churned customers and from downselling. Does this have anything to do with your lemonade agency?
Penny: No, but let’s pretend it does. What happens if Chad leaves?
Deborah: He’s your biggest customer, right? If you lose him, you’d lose 33% of your customers, so you’d have 33% customer churn. Since he represents half of your revenue, though, you’d have 50% dollar churn. Picture it like this.
Deborah: Now, let’s pretend you lost Timmy instead. You’d still have 33% customer churn, but since he only accounts for 20% of your revenue, you’d have 20% dollar churn.
Penny: Dangit. I hate churn.
Deborah: Yes, it’s terrible. But you can have negative churn, too.
Penny: What’s that?
Deborah: Negative churn is when expansion revenue from customers is greater than revenue lost from churning customers. Say Timmy and Sheena left, but Chad’s business grew from $500 MRR to $1,200 MRR. You’d have 66% customer churn but -20% dollar churn. You want negative churn. It means your customers are growing.
Penny: Geez Louise. What does all of this mean for my business?
Deborah: A lot. Churn affects your customer lifetime, which affects lifetime value.
Customer Lifetime = 1 / Churn
LTV = Avg monthly profit per customer x Customer lifetime
Deborah: Let’s say you lost one of your three customers already—that’s 33% monthly churn. Keep going at that rate, and you’ll lose all your customers in three months. Your company won’t be able to pay back its initial $5k investment, and that’s a lot of allowances, missy.
Penny: So what’s a good churn rate to aim for?
Deborah: Let’s Google it. Ah, there we go. A study from BVP says an acceptable annual churn rate is 5 - 7%, or .42% - .58% monthly, depending whether you measure customers or revenue. That works out to losing 1 in 200 customers per month (BVP). Likewise, Pacific Crest found that 75% of SaaS companies had 5% annual churn or under (Pacific Crest).
Penny: Oh boy.
Deborah: Yup. A high churn rate is the reason you can gain a bunch of new customers in a year but end up with the same amount of revenue. It reminds me of this quote from David Skok that I tried showing your father once.
“If you’re only $10M in revenue and you’ve got a 2.5% monthly churn, by the end of that year you will have lost $3M of your revenue, and that isn’t such a terrible problem. I mean, I can easily
hire some salespeople to go and get another $3M in revenue. But if I’m four years later than that, I’ve gotten to $100M in revenue and I’ve still got a 2.5% churn rate, then I’ve got a huge problem on my hands. I’ve now got to find a new set of customers to replace $30M of revenue, and that’s nearly impossible to do. What this tells you is you can afford to have churn when you’re small and young and not panic about it, but as you get bigger, you absolutely cannot afford to have it.”
Penny: Wait a tick. Did Mr. Skok just say that you can afford to have churn when you’re young? So it’s not too late to save my agency?!
Deborah: No, but you better do something soon.
Penny: What? What should I do?
Deborah: I’ll tell you the same thing I told your father. Number one, deliver a service model that’s right for your clients, and number two, focus on proof of performance.
Penny: Quick—what’s a service model?
Deborah: A service model is how you deliver services to your clients. Are you selling self-serve products—in other words, are you offering Do It Yourself solutions—or are you managing solutions on their behalf? Your lemonade clients aren’t very marketing savvy; I bet they don’t know how to use the software you gave them. Maybe you should charge them more to manage everything yourself. That’s called DIFM, by the way. “Do it for me.”
Penny: Gotcha. And what’s proof of performance?
Deborah: Proof of performance is about making sure that your clients understand the value you’re delivering. You might be doing a lot for them, but it can be difficult to prove that your efforts are paying off. You want to make sure you have clear reporting set up so you can share results on a regular basis, as well as things like alerts and notifications so your brand stays top of mind. The more you can prove that you’re providing value, the less likely they are to churn.
Penny: Thanks, Mom. I won’t let you down.
Deborah: Please don’t. My credit score is depending on it.
Chapter Four: Penny cracks the client retention code
Everything Penny’s mother told her about service models and proof of performance went straight to heart. She had no doubt that her remaining clients, Timmy and Sheena, were too bush-league to use the marketing software she had sold them, and if they weren’t getting any value from it, they’d churn.
There were two problems: 1) Penny didn’t have the time or expertise to manage Timmy and Sheena’s online marketing herself, and 2) She didn’t know how to show proof of performance.
Luckily, there was an easy fix. Turns out the company whose software she was selling had a white-label digital agency that she could use to provide DIFM services.
Instead of trying to offer all the products under the sun, Penny figured she should focus on business listings, reputation management and social marketing, since those would have the greatest impact for Timmy and Sheena. Here are the three packages she came up with.
Armed with these managed service solutions, Penny returned to Timmy and went for the upsell.
Penny showed Timmy the following pricing chart, and it worked. Timmy pointed at the Protector PLUS package and signed on the dotted line. Now he would have his online reviews responded to by a professional, his listings corrected and social posts made on his behalf twice a week, as well as a monthly progress report, for $500/month.
Penny also convinced Sheena to upgrade to the Protector PRO package for $700 per month. Finally, even though Penny had 33% customer churn from losing Chad, she had compensated for it with what was shaping up to be -20% dollar churn. Score!
It was time to celebrate.
Penny picked up a bag of Hickory Sticks (her favorite snack) and raced home. When she stepped inside, she saw her mother sitting on the living room couch watching TV.
Deborah: Penny, have you seen the news today?
Penny: No. Why?
Deborah: The police are investigating massive fraud in our neighborhood. Sounds like people are reporting thousands of dollars in unauthorized credit card charges to a corporation called Peas & Carrots Ltd. I wonder what that’s about.
Penny: Huh. Beats me.
Penny glanced out the window at Timmy’s house. Timmy’s lemonade stand was swarming with customers, and for once, he had a smile on his face. Penny smiled back and then went to her room and started brainstorming ideas for her next business.
- SaaS = software as a service
- MRR = monthly recurring revenue
- CAC = cost of acquisition
- LTV = lifetime value
- Customer lifetime = 1 / Churn
- Negative cashflow = When more money flows out of a business than flows in during a specific period.
- Churn = the proportion of customers or subscribers who leave a supplier during a given time period.
- Customer churn = The number of customers you lose over a period of time (also called logo churn).
- Dollar churn = Lost revenue from churned customers and downselling.
- Negative churn = When expansion revenue is greater than revenue lost from churning customers.
- Service models = Methods of client fulfillment for digital solutions. Types of service models include Do It Yourself (DIY), Do It For Them (DIFM), and Do It With Me (DIWM).
- DIY = Do It Yourself = a service model where clients are responsible for their own usage of the products they purchase.
- DIFM = Do It For Me = a service model where solution providers are responsible for providing fulfillment services to end users based on the products they have sold them.
- DIWM = Do It With Me = a trademarked service model from Vendasta. It encompasses Digital Agency collaboration with local businesses for balanced fulfillment.